closed-end funds

Investment companies in the US are a specialized form of corporation that is exempt from corporate income tax, a privilege they get in return for agreeing to restrict activities to investing in securities and to distribute to shareholders virtually all their realized profits (which become taxable income to recipients).

The predominant form of investment company is the mutual fund/exchange-traded fund, also called an open-ended fund. What makes the fund “open-ended” is that the investment company itself regularly issues new shares to buyers and redeems them from holders who wish to sell. Put another way, the number of shares of the company–and therefore the amount of money under management–is variable. It typically ebbs and flows with market sentiment or with the track record of the professionals the company hires to manage the money.

A less common form of investment company is the closed-end fund. In this format, the investment company raises initial capital in an IPO and trades its shares on an exchange. It does not allow shareholders to purchase and redeem directly from the company (the reality is slightly more complicated, but nothing to worry about). Instead, buyers and sellers find a counterparty on the exchange, just as if they were selling a regular stock or bond.

What makes closed-end funds interesting to you and me is that they almost always trade at discounts to net asset value. There are some exceptions, like if they specialize in some exotic foreign market that’s hard to invest in directly and which happens to be flavor of the month, or if the managers have been shoot-out-the-lights successful in their investing (I can’t think of one in this second category).

This is particularly true in times of stress.

If the discount to NAV becomes too great, or persists for too long a time, predators may try to take control of the fund and liquidate it–which, of course, makes the discount disappear as well as the fund.

Why am I writing this today? …because I’ve been reading that closed-end bond funds are trading at unusually high discounts to NAV at present. I presume that this is in anticipation of higher interest rates.

I’m by no means an expert on these funds. And I can’t imagine rushing out to buy bonds today. But these may be a class of securities to begin to learn about and keep an eye on.